The Business of Banking
Banks are intermediaries for capital and hold the risk when supply and demand is not perfectly balanced. Historically, commercial banking and investment banking functions have been separated by law – these restrictions have since been repealed and larger banks tend to take on capital markets operations due to the complimentary nature of the businesses.
Commercial Banking
In traditional commercial banking, banks extend loans to borrowers (individuals or organizations) and source funds from savers (depositors or purchasers of certificates of deposit). Whenever money is lent out, there is a risk the borrower will be unable or unwilling to repay the loan. The risk of loss and burdensome nature of due diligence (evaluating the creditworthiness of each borrower) make it impractical for the everyday person or organization to make these loans. A bank, on the other hand, can diversify this credit risk and reduce the average cost of vetting each loan by lending to many borrowers. If the bank does its job well, it can achieve an acceptable loss ratio that makes the aggregate loan book profitable despite some individual loans not being repaid. As the bank takes the risk, it is said to be underwriting the loans. As the bank is the counterparty of both the borrower and the lender, the bank indemnifies depositors from the risk of loss.
Investment Banking
Investment banks are split between capital markets and corporate finance (also known as investment banking). In the capital markets, investment banks underwrite securities, such as debt or equity, acting as the bridge between capital and organizations that required it. In secondary markets, the sales & trading function operates as a market maker. They help to match sellers with buyers (playing the role of a broker). Or, in the absence of any buyers, they act as a dealer, offering to buy for a certain price and then looking to offload the securities on the other end. In investment banking advisory, usually in the realm of M&A, spin-offs and divestitures, investment banks provide support to organizations that are looking to sell assets or entire businesses. This is fee generating business that does not require the investment bank to take on any underwriting risk.
Today, most global banks are diversified financial institutions with operations beyond the scope of normal banking, and may have a business mix more reflective of the following:
- Personal & Commercial Banking (Retail/Commercial) – this will be the main focus of this post
- Investment Banking – Capital Markets (Wholesale Banking) and Corporate Finance
- Wealth Management – wealth management is heavily favored today in bank strategy due to low capital requirements – the business model was covered in the series on Asset Management
- Insurance
Commercial vs Retail Banking
For the sake of this post, it is important to understand the basic distinctions between commercial and retail banking. Commercial banking can be sub-divided into money center, business banks, and trust banks. While on the retail banking side, there are consumer credit providers and mortgage lenders.
There are many different types of banks. Here is a high level summary of the main types of commercial and retail banks:
- Commercial banks: As the name would imply, these are banks that focus on commercial customers. There are three broad categories of commercial banks:
- Money centers: Banks that focus on large corporates and provide investment banking services. Despite the categorization, these banks often have a high mix of consumer loans as they run standalone credit card businesses.
- Business banks: Banks that focus on mid-sized businesses and commercial real estate. They are almost always highly asset sensitive (i.e. earnings go up when rates rise) as they have floating rate loans and lots of non-interest bearing deposits.
- Trust banks: Banks that provide custody and deposit services for large asset managers.
- Retail banks: Banks that service retail or individual clients. These include:
- Consumer credit providers: Banks that provide credit card, auto and student loans. Margins are generally higher than average, with more exposure to the credit cycle and less from interest rates.
- Mortgage lenders (thrifts): The more mortgages that a bank has on its books, the more liability sensitive it will be – earnings go up when rates go down as long dated fixed rate mortgages are funded by short dated certificate of deposits (CD).
Bank Income Statements
At the core, retail/commercial banks primarily make money on the spread between the interest rate they charge for loans and the interest rate they pay deposit holders.
On the income statement, banks calculate revenue by combining net interest income and non-interest income.
- Interest income is earned when banks collect interest on loans.
- Non-interest income includes transaction fees, account fees, servicing fees, credit card usage fees and fees related to mutual funds (trailer and management expenses are sometimes booked to wealth management revenues).
1. Interest Income
Banks lend money to individuals, businesses, and governments through a variety of loans and collect interest payments. What the interest rate will be is a function of the bank’s cost of funding, the bank’s relationship with the counterparty, and the nature of the loan: size, tenor, credit risk, and security.
For banks to lend money out, funding is required. The cheapest form of funding is deposits (particularly retail and small business deposits). These accounts pay little to no interest and are fairly “sticky” – so banks will fight to attract deposits. Retail deposits are where the bank captures the highest spread for a longer-term loan. Banks also obtain funds by offering a variety of financial products, including Guaranteed Income Certificates (GICs) in Canada and Certificate of Deposits (CD) in America, where banks pay a slightly higher interest rate but benefit by being able to lock funds up for a specified period of time. After cheaper sources of funding have been exhausted, banks can turn to wholesale funding (where the duration of funds can be more closely matched to that of the loan). For instance, if the bank provides a 5-year mortgage, it can source 5-year funding.
All lenders care about interest income, but banks also have to weigh profitability against capital reserve requirements. Although mortgages do not necessarily pay high interest rates, they do not eat up any capital due to the safety of the financial product and implicit government guarantees.
2. Non-interest Income
Banks collect a variety of fees from:
- Accounts (monthly fees for chequing and savings accounts vary depending on the level of service offered – unlimited withdrawals, use of ATMs, etc).
- Transactions (ATM withdrawals, overdraft charges).
- Credit cards (a percentage charge for use paid by the vendor, annual fees for special cards).
- Various other products.
If fees are recurring, these are good revenues as they have ancillary revenue potential (banks can bundle and cross-sell) and do not put pressure on the bank’s capital (no capital has to be held against fee revenue).
Credit card usage is distinct in Canada, where the market is dominated by the banks (rather than credit card companies as in the US). Credit cards in Canada are primarily used as a transaction facilitator rather than as a lending vehicle – whereas in the US, credit cards may be seen as a working capital loan (accordingly, interest rates on American credit cards are a lot lower on average than in Canada). Credit card debt in Canada comes with steep interest rates and serves as a profitable product for banks.
3. Provisions for Credit Losses
There is default risk inherent in lending (if there was no risk, there would not be a profitable interest margin), so it is expected that a certain amount of loans will go bad and become uncollectable. Banks record an allowance for credit losses on the income statement as a bad debt expense in order to avoid overstating income.
4. Asset and Liability Matching
Banks try to match the duration of assets and liabilities in order to negate interest rate risk. Duration is a measure of how sensitive the market value of a financial security is to a change in interest rates, the higher the duration the more interest rate risk. Liabilities (funding via deposits) usually have a shorter duration than assets (loans), which means that the bank’s surplus (excess of assets over liabilities) will often be invested in short duration financial instruments to immunize the portfolio from interest rate risk. As such, higher short term interest rates benefit banks.
Banks refer to interest rate risk as “asset sensitive” or “liability sensitive”. Translated into plain English, asset sensitive means margins expand when the Federal Funds rate increases, as the interest income from assets on the balance sheet increase faster than liabilities. Liability sensitive is simply the other way round, margins contract as the Federal Funds rate increases as the interest payments on liabilities increase faster than interest income from assets.
Banks abide by strict asset-liability management limits. Banks invest in certain types of assets (mortgages, bonds, personal loans, auto loans, securitized instruments) that they hold against liabilities (deposits, bonds). Assets should always exceed liabilities with the surplus being invested in short-term securities that are cash like (Federal Funds, short term bonds, commercial paper) in order to bring down the total duration of the bank’s assets. This is because the duration of assets must match the duration of liabilities so that the bank’s net asset position is insensitive to changes in interest rates.
- If assets move more than liabilities, then the bank’s equity value will fall when interest rates rise.
- If liabilities move more than assets, then the bank’s equity value will fall when interest rates fall.
Matching liabilities with assets and rebalancing when interest rates change is important in order to ensure that a bank does not see fluctuations in its equity value that are unrelated to its operating business.
5. Funding and the Loan Mix
Banks have huge balance sheets well in excess of their equity value due to all deposits being liabilities – the balance sheet is the business. Banks hold a lot of cash as well – a figure that can be substantial enough to push enterprise value (EV) to a negative number (enterprise value = debt + equity + preferred shares – cash + minority interest).
Since banking is an industry that everyone needs access to as a convenient means of receiving, storing, and making payments, banks are heavily regulated. Deposits are insured by the government up to C$100,000 in Canada and up to US$250,000 in America. As the government would prefer to not have to step in, banks have very tight restrictions on what assets they can buy with customer deposits.
The best source of funds is deposits because interest rates paid to depositors are zero or close to zero. In Europe, certain banks even charge depositors for the right to deposit as depositing is a service. The downside with deposits as a source of funding is that they can be withdrawn on demand, which means that banks are exposed to liquidity risk (running out of cash) if there is a loss of confidence in the banking system (which is a key reason why deposits are insured by the government).
Certain deposit accounts (e.g. savings accounts) are stickier, and accordingly, require the bank to pay a higher interest rate.
Banks price loans based on a required return on capital for the marginal loan – that is the most expensive cost of funds. For instance, if a homeowner takes on a 5-year loan, the bank will charge a spread over its cost of funding this loan in the wholesale market (possibly selling a 5-year bond, so that assets match liabilities). If the bond requires the bank to pay 1%, the bank may charge the customer 2%, thus capturing a 1% spread. However, if the bank has sufficient deposits, the spread would be the entire 2%. If we assume that the duration of the 5-year loan is 5 years (an asset from the bank’s perspective) and the duration of deposits is zero (a liability from the bank’s perspective), then there is a mismatch in duration that needs to be balanced. The bank can do this by investing excess capital in very short term securities.
Conclusion
A banking business model can be both very simple and extremely complex depending on the different revenue streams it has (interest, transaction fees, financial advice, etc.) and what kind of business mix it consists of (retail banking, commercial banking, investment banking, wealth management, and insurance).
Nonetheless, this post was written in the hopes of providing a good understanding of how everything interacts within the financial services industry.
Jason Oh is a management consultant at Novantas with expertise in scaling profitability and improving business efficiency for financial institutions.
Image: Pexels
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